Unchained Podcast - Jake Chervinsky on Crypto's Current Legal Fights

In this episode of Unchained which took place on April 23, 2024, Laura and Jake discuss the current state of crypto regulation, ongoing legal and regulatory issues, and more. Read our notes below to learn more.

Background

Laura Shin (Host) – Crypto journalist, Host at Unchained
Jake Chervinsky (Guest) – Chief Legal Officer at Variant Fund

The importance of the Tornado Cash case for open-source software

Jake says that open-source software developers may face liability for unforeseen illicit uses of their software, as per government premises. The case involving Tornado Cash highlights the government’s unprecedented actions against open-source developers.
He adds that the government alleges that developers are responsible for third-party misuse, despite making the software immutable and publicly available. It is important to distinguish between holding developers accountable and rooting out bad actors in the financial system.
Jake says that the government wrongly portrays Tornado Cash as a service operated by its developers, combining various elements like smart contract protocol, governance token, and user interface. To prove sanctions violations, the government must establish active engagement between Tornado Cash developers and sanctioned parties. However, no direct interaction is alleged in this case.
He adds that similarly, for money laundering charges, the government needs to show that defendants agreed to conduct transactions for concealing ill-gotten gains. Allegations against Tornado Cash developers lack evidence of facilitating such transactions.

Jake’s view on the government’s concerns over financial systems it can’t surveil

Jake says that the complaint highlights developer control over the user interface and payments made for hosting services. It also mentions founders’ allocation percentages and discussions regarding compliance features like KYC.
He adds that despite these facts favoring the government’s case, they remain circumstantial. Involvement in user interface management and profit from token allocation do not directly establish criminal liability without evidence of active engagement with sanctioned parties or money laundering transactions.

Possible outcomes of the motion to dismiss in the Tornado Cash case

Jake says that a motion to dismiss the indictment is pending, with a response expected soon. The court will rule on this motion, but it’s challenging to get an indictment dismissed. If the case progresses beyond the dismissal stage, there will be discovery where both defendants and the government exchange information. This process may lead to pre-trial motions and a trial, potentially extending into next year.

Potential implications of the Tornado Cash case for the DeFi sector

Jake says that delays in trials are common due to discovery disputes. There’s also a possibility of the government walking away from the case or defendants changing their plea. The impact extends beyond Tornado Cash; if legal theories hold, all open-source software developers could face liability for unforeseen uses of their software.
He adds that the criminal liability theories in this case could affect all software developers globally, not just in crypto. It poses a threat to open-source movements by holding developers accountable for unintended uses of their software.

Lessons from the $62 million hack of Munchables

Jake says that following a $62.5 million hack on Munchables by a North Korean developer, community members negotiated money return. Regulators observed this incident closely. Lessons include enhancing cybersecurity standards within crypto to prevent bad actors like the Lazarus Group from exploiting vulnerabilities. Addressing cyber threats involves industry collaboration and robust protocols.
He adds that policymakers consider preventing illicit transactions through cybersecurity measures while also strategizing how to deny bad actors benefits post-hack. The incident highlights industry unity against the misuse of funds.
Jake says that centralized entities have a moral duty to prevent bad actors from abusing decentralized systems.

Dealing with malicious actors in a permissionless system

Jake says that striking a balance between access to financial services and mitigating risks posed by illicit actors. Addressing the exclusionary nature of the current financial system that hinders billions from accessing financial services. Advocating for DeFi as a means to democratize finance while acknowledging the need for risk mitigation strategies.
He adds that embracing crypto-native compliance tools is essential for mitigating risks in a trust-minimized environment. Companies develop compliance tools that identify potential risks without excluding users based on identification criteria.

Judge Failla’s partial agreement with the SEC in the Coinbase case

Jake says that Coinbase‘s motion challenges the SEC‘s interpretation of securities laws regarding token classification. He provides an update on Coinbase’s legal actions against the SEC, emphasizing disagreements over defining investment contracts under the Howey test.
He adds that an asset cannot be classified as a security if there are no post-sale or post-distribution obligations to the holders. The precedent suggests that a post-sale obligation has always been required under securities laws. The SEC’s interpretation implies that every digital asset is a security due to the ecosystem around it, even without post-sale obligations defined clearly.
Jake says that Coinbase seeks an interlocutory appeal on the issue, considering it a pure question of law. The case aims to move towards appeal rather than proceeding with discovery and trial immediately. Seekinga resolution on this issue is crucial for understanding the SEC’s jurisdiction in crypto contexts.
He adds that different judges provide conflicting rulings on whether an asset constitutes an investment contract. Ripple’s case exemplifies opposing views within the same court regarding what defines an investment contract.

The possibility of an investment contract without an actual contract

Jake says that the appeals court would analyze the term “investment contract” under the Securities Act of 1933 without focusing on specific tokens. Resolving this fundamental legal question would guide further proceedings in district courts.
He adds that Judge Failla expressed surprise at how ecosystems determine asset classification during oral arguments.
Jake says that Supreme sold a brick with the word “Supreme” on it for hundreds of dollars, showcasing how their luxury brand status led to high demand for even unconventional items. Despite Supreme’s unique marketing tactics, questions arise about why the company is not considered a Securities issuer or registering its products with the SEC.
He adds that Judge Failla highlighted the lack of a limiting principle in the SEC’s ecosystem theory, suggesting potential implications for cases involving investment contracts like those related to the Supreme.
Jake says that Judge Failla validated the SEC’s theory in her opinion regarding investment contracts, indicating a concrete stance rather than deferring decisions based on factual uncertainties. Instead of postponing judgment due to factual ambiguities, Judge Failla opted to establish legal principles that warrant appellate court review before progressing further in the case.

Whether Coinbase’s staking services constitute a securities offering

Jake says that the SEC claimed that Coinbase’s staking service constituted a Securities offering due to managerial aspects unrelated to underlying asset securities.
He adds that airdrops have emerged as a primary means of token distribution, where tokens are given for free rather than sold. Understanding legal and regulatory strategies around airdrops is crucial to ensure compliance with securities laws.

Potential for other courts to overturn Judge Failla’s ruling on Coinbase

Jake says that the ruling that Coinbase is not considered a broker in its wallet service was deemed favorable for the industry. Questions arise about the ruling’s binding nature across jurisdictions and potential challenges from other judges.
He distinguishes characteristics between brokers (making decisions for customers) and software providers (offering tools for user decisions). He highlights Coinbase’s role as a non-custodial software provider enabling users to interact with decentralized exchange protocols independently.

Jake’s perspective on the SEC’s challenges in the Uniswap Labs case

Jake says that there are three key aspects under scrutiny: wallet/web app status, $UNI token classification, and decentralized exchange securities exchange evaluation.
He adds that Uniswap argues for decentralization akin to the Ethereum ecosystem as described by Bill Hinman in 2018.
Jake compares between the Uniswap Wallet and Coinbase Wallet regarding custody of user funds.

Potential use of Uniswap licenses in the SEC’s arguments

Jake says that controversy surrounds restrictive business licenses within the crypto community.

Reasons for the SEC’s interest in the Ethereum Foundation

Jake says that there is raw speculation about potential reasons behind the reported investigation without confirmed details.
He adds that the SEC views most crypto assets, except $BTC, as securities. Chair Gensler has not explicitly stated that $ETH is not a security, indicating a negative view towards it.
Jake says that the SEC faces pressure regarding approving or denying a spot $ETH ETF. Political factors influence the decision-making process, potentially leading to justifications for denial.
He adds that rumors suggest the SEC may differentiate between proof of work and proof of stake assets to classify $ETH as a security. However, arguments against this classification exist based on staking dynamics.
Jake says that denying the spot $ETH ETF could create conflict within the Biden Administration due to differing views between the SEC and Commodity Futures Trading Commission (CFTC) on $ETH’s classification.

Impact of the Debt Box case order on the SEC’s reputation

Jake says that the SEC is taking extraordinary litigation risks by not acting as a neutral arbiter but rather pushing boundaries to win at all costs. This aggressive stance damages its reputation. The culture of hostility and antagonism within the SEC leadership has influenced enforcement attorneys, leading to misconduct labeled as a gross abuse of power by judges.
He adds that misconduct within the SEC is seen as indicative of systemic issues stemming from leadership’s flawed perspective on regulation, tarnishing its reputation with both judges and regulated industries.

How the industry is responding to the SEC’s enforcement tactics

Jake says that the industry is fighting back against the SEC with lawsuits like DeFi Education Fund/Beeba cases to set precedents beneficial for the wider industry. These lawsuits aim to challenge the SEC’s interpretations of laws and regulations, seeking clarity through impact litigation strategies rather than passively waiting for SEC actions.
He adds that the SEC has an unwritten policy regarding digital assets that has been enforced through regulations without formal documentation.
Jake emphasizes the significance of the Administrative Procedures Act (APA) in providing a platform for public participation in rulemaking processes.
He criticizes the SEC for creating laws independently without oversight from Congress or public input as required by law.
Jake stresses the importance of involving multiple judges across different districts and circuits to establish clarity on legal interpretations. He advocates for the involvement of multiple circuits to obtain diverse perspectives leading up to potential Supreme Court intervention for regulatory clarity.

The debate over whether unhosted wallets are brokers

Jake highlights the IRS’s expansion of broker definition under tax code post-bipartisan infrastructure bill with vague terms causing uncertainty in the application.
He adds that the Treasury Department’s efforts to combat perceived tax evasion in the crypto industry despite limited evidence supporting widespread evasion practices.
Jake says that unhosted wallets are now considered brokers by the IRS. Concerns were raised about treating software as a middleman for customers. There are potential implications where developers may be responsible for user identification. There are legal and constitutional concerns regarding defining unhosted wallets as brokers.

The outlook for DeFi in the US and its potential to thrive

Jake says that he has confidence that DeFi can succeed in the US with proper compliance.
He puts emphasis on educating policymakers and regulators about the importance of DeFi technology.

Jake’s views on the SEC’s stance on Ether ETFs

Jake predicts that the SEC will deny $ETH ETF approval. There is a political reluctance within the SEC towards approving industry-related products like the $ETH ETF.
He refers to a split vote on $BTC ETF approval despite legal rulings. Commissioner’s dissent indicating potential reasoning for denying an $ETH ETF.

Jake’s disagreement with the latest stablecoin regulation bill

Jake says that legislation should prioritize regulating centralized custodial stablecoins due to the known risks associated with financial institutions holding funds.
He adds that the Lummis Gillibrand Payment Stablecoin Act restricts various stable coin types, including algorithmic payment stablecoins, limiting innovation in the industry. Criticism is raised against the bill for banning certain stablecoins and mandating issuance only by depository institutions like banks.

How the US Presidential election could influence the industry’s future

Jake says that uncertainty surrounds how a second term for either President Trump or a new Biden administration would impact crypto regulation. President Trump’s mixed stance on crypto during his first term raises questions about future policies if re-elected.
He adds that a second Biden term might be less favorable for crypto due to perceived hostility towards business and innovation.
Jake puts emphasis on Congress’s role in defining laws related to market structure and regulatory jurisdiction over the industry.
He adds that the significance of voters considering candidates’ views on crypto during elections is due to the influence of millions of American voters who base their decisions at least partially on this factor.
Jake says that observations suggest a shift in older politicians displaying more negative stances post-FTX, while younger politicians tend to hold more positive views regarding cryptocurrency.

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Show Information

Medium: YouTube (Video)
Show: Unchained
Show Title: The US vs. Crypto: Jake Chervinsky on Crypto’s Current Legal Fights
Show Date: April 23, 2024